I promise not to talk about the lessons from 1987

I'm sure you've had enough of that today. But there is a related point worth mentioning.

Why did the crash have so little impact outside of Wall Street (particularly compared to the 90's bubble)? A 34% drop from peak to bottom in the S&P 500 a matter of months certainly packs a punch. Surely the Fed's timely intervention helped. But by and large, it was simply a matter of the stock market being so much less relevant than today.

While in the previous five year period before the 1987 peak it had gained around 24% annually, slightly more than the comparable rise before the 2000 peak, it came from a much lower base. In 1986, stock market capitalization to GDP was merely 60%, compared to 110% in 1999, while direct equity holdings represented only 14% of household financial assets, versus 29% in 1999. Also, valuations in mid-1987 were, with a P/E of 20 times, much more reasonable than the 30+ times seen in early 2000.

What mutual fund flows say about rising stock prices

Given all the negative economic news, many are wondering why stock prices are rising (the S&P 500 has jumped 10% from its August 15th low and has gained 6.3% from its end of July level).

Valuation factors certainly don't seem to justify this rise. After all, many forecasters are slashing U.S. growth forecasts significantly. Goldman Sachs reduced expected 2008 growth from 2.6% to 1.8%. And long term interest rates haven't changed much, although certain credit spreads have eased.

Most likely, stocks are benefiting from asset allocation changes, as noted here. Lower short-term interest rates make money market investments less attractive, while corporate bonds don't look very attractive given the recent turmoil. That leaves stocks as pretty much as the less ugly alternative.

Capital flow data from mutual funds (a less than perfect indicator, but the only current one we've got) backs this up, to a degree. In August, according to AMG Data, equity funds received a net inflow of 5.7 billion, while taxable bond flows saw an outflow of 0.8 billion. However, money market funds saw a staggering inflow of 156 billion.

In the second quarter, taxable bond inflows were twice as big that equity inflows.

More recent weekly data has been seen similar trends, although it seems that taxable funds are attracting some interest again.

Winners and losers

Which stock market sector has had the worst performance so far in August? If you answered financials, you (and I) were wrong. Taking the S&P Global 1200 as reference, it turns out that materials, energy, industrials and consumer discretionary all performed worse than financials.



This is not as strange as it may seem. Look at year-to-date results (YTD). Financials are the worst performing sector, as expected. This means that the damage inflicted by this crisis had been reflected in valuations before the lates news. Which is fairly good news. The bad news is that the sectors who fell most this month are cyclicals, which means that worries about global growth are rising.

Geographically, so far this month emerging markets have donde worse than developed markets and the US has done better than Europe. This has identical meaning to the sector breakdown above. The bad news is already in US stock prices (well, as long as more unanticipated bad comes along) and worries about growth are spreading to the stronger economies (Europe, emerging markets).

So how're Fannie & Freddie?

They're doing surprisingly well, thank you for your concern. In one of those strange twists of history, after a series of accounting and management scandals Freddie Mac and Fannie Mae were placed under a short leash, which seems to have greatly limited their exposure (see here and here) to the subprime sector. Just look at the performance of their stocks (FRE, FNM):





This is very good news. The markets will need all the help they can get and Freddie Mac and Fannie Mae can play a crucial market making (and thus liquidity-providing and price-creating) role, hopefully coordinating with the Fed. I'm sure we'll be hearing a lot more from them very soon.